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Tomorrow's Winning Stocks Are Right Here

You won't find them in the obvious places.

When you're looking for tomorrow's best stocks, you know that the best place to search is where no one else is looking. Although that makes sense intuitively, it took an expert stock researcher to quantify just how much more valuable those hidden gems can be, compared to the stocks that everyone already knows about.

Ibbotson speaksWhen it comes to market platitudes, market historian Roger Ibbotson takes nothing for granted. Ibbotson was one of the pioneers of applying historical market returns to making decisions about asset allocation. He's also tackled tough questions like the exact amount of disposable income people should set aside for their retirement savings.

Recently, Ibbotson took on an interesting conundrum: how the trading volume of a given stock affects its return. By defining liquidity as the total trading volume of a stock divided by its total shares outstanding, Ibbotson portioned a universe of 3,500 stocks into four parts, rebalancing them every year and studying their returns from 1972 to 2009. He found that the least-often-traded, most illiquid stocks had higher returns than the popular, most-often-traded stocks.

The relationship of higher return from less trading volume, applied across the investment spectrum, showed itself in several areas. Among small-cap stocks, highly liquid issues performed badly, returning just 5.9% annually over the period. In contrast, illiquid small-caps returned an average of 17.9%. Comparing growth versus value stocks, highly liquid growth stocks had returns of just 3.3%, versus 20.6% for illiquid value stocks.

Where the winners areCorrelating winners with low volume is a tough thing to do in hindsight. After an individual stock has taken off, everyone knows about it. Look at the past year's top performers:

Stock

1-Year Return

Average Daily Volume

Shares Outstanding

Miller Petroleum

910%

161,000

33.4 million

IDT(NYSE: IDT)

496%

220,000

22.6 million

Power-One(Nasdaq: PWER)

403%

2.56 million

106.3 million

American Oil & Gas(NYSE: AEZ)

391%

1.04 million

61 million

VirnetX Holding(NYSE: VHC)

380%

471,000

47.4 million

Source: Capital IQ, a division of Standard & Poor's.

These companies may still not be household names, although stock followers know them well from their place atop the performance charts. IDT, Power-One, and American Oil all have carved out niches within the energy industry, with IDT sporting a unique combination of phone cards and energy services. These businesses are also small; VirnetX has just 12 employees.

But with most of these stocks trading 1% or more of their outstanding shares every day, they aren't good representatives of illiquid stocks. After all, even ExxonMobil only trades half a percent of its shares on a typical day. But when you go back and look at these stocks a year ago -- before they'd run up -- you'll notice that the trading volume was a lot lower.

What to doThe lesson here isn't to give up on actively traded stocks. But realize that when you buy stocks with a lot of liquidity, you're paying up for it -- and if you're a long-term investor, you're paying for liquidity that you're not planning to use.

Conversely, you shouldn't let illiquid stocks scare you off. For instance, Prestige Brands(NYSE: PBH) is a consumer stock that sells well-known brands like Chloroseptic and Comet. But it's a small-cap stock, so it trades only a small fraction of the volume Procter & Gamble(NYSE: PG) or Clorox(NYSE: CLX) sees in an average trading session. Yet despite its relative unpopularity, Prestige trades at a similar valuation to P&G and Clorox, even though analysts expect it to grow much faster than its larger competitors.

The concern is that for stocks that trade only a couple million dollars in shares each day, relatively modest orders can move the market. But if you're planning to buy and hold for years, taking the time and effort to use limit orders to scale into your position will work -- and you won't have to worry about it until you sell years from now.

Get what you pay forIf you want top returns, looking to actively traded stocks isn't going to get you onto the top 10 list. By searching for stocks no one else has heard of, you'll have the best chance to uncover tomorrow's true best performers.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributorDan Caplingerloves turning over rocks to see what's underneath. He doesn't own shares of the companies mentioned in this article.Clorox and Procter & Gamble areMotley Fool Income Investorpicks. The Fool owns shares of and has written covered calls on Procter & Gamble. The Fool owns shares of ExxonMobil and Prestige Brands Holdings. Try any of our Foolish newsletters today,free for 30 days. The Fool'sdisclosure policyis a better archaeologist than Indiana Jones on his best days.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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